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Too Much Strictness Brings No Benefits

Among the plentiful analyses carried out on the causes that led to the financial crises that threatened to devastate the world’s major economies from 2007 to 2017, a statement by Nobel Prize Paul Samuelson brilliantly summarizes the situation. A month after the bankruptcy of Lehman Brothers, the American economist stated that “at the bottom of this worst financial mess in a century is this: Milton Friedman-Friedrich Hayek libertarian laissez-faire capitalism, permitted to run wild without regulation.[…]. Both of these men are dead, but their poisoned legacies live on.”

Justifiably, the political leaders of the most important countries of the world demanded the Regulators to drastically reduce the chance to come close to such a situation again. The Regulators’ response, equally justified and strong, has led to a veritable “regulatory tsunami” over the last decade. Thousands of measures aimed at reducing risk have made granting of credit to the economy stricter and more controlled. In Europe, the main targets were the countries with the highest public debt and the banking sectors whose models were mainly based on lending to households and businesses.

Allow me to take a quick step back in time by about a century and make a thought experiment. At the end of 1918, the economist John Maynard Keynes was called to join the British delegation at the Paris Peace Conference. He became increasingly concerned about the negotiations taking place, and particularly about the extremely punitive attitude towards Germany of WWI winner countries. Keynes pointed out that it was essential to reach an equitable solution with regard to the varying debt levels of all the warring countries, both victors and losers, and to include German reparations to pay damage caused by the war within this framework.

He was ignored. In June 1919, in just a few weeks, he wrote The Economic Consequences of the Peace. Here, he stated that the French idea of imposing “Carthaginian peace” on Germany had prevailed in Paris. Keynes forecasted that such onerous-reparations would never be paid. They would make Germany unable to get back on its feet with awful political consequences. As we know, he was terribly right.

Fortunately, the victors of WWII tried not to repeat the mistakes made at the Paris Conference and introduced cooperation agreements and aid even for the countries that had lost. Italy came out of WWII devastated, and yet was able to develop into the second largest manufacturer and the second most export-oriented economy in Europe, despite lacking raw materials and capital.

Now, I have tried to apply this history lesson to the current European and Italian situations. Even if we live in a very different era and are no longer talking about wars and unspeakable suffering, I believe that we should not underestimate the signs of serious hardship being experienced by important parts of contemporary societies.

Against this backdrop, the “regulatory tsunami” is having negative impact on lending. The situation is likely to become more complicated with the new Guidelines on loan origination and monitoring. And bank lending in Italy, as well as in many other European nations including Germany, is still vitally important for millions of micro and small businesses.

The Authorities have, at times, tried to assess the effects of financial regulatory reforms on the financing of small and medium-sized enterprises. Focusing on the Basel III regulations, the Financial Stability Board recently observed in a study that, even with a negative transitional impact on the supply of loans to SMEs, the net effect over the long-term would be positive. A higher capitalized and more liquid banking sector would be an advantage both in terms of financial stability and growth, with benefits outweighing the initial costs.

This study does present some shortcomings. The results from the empirical analysis do, in fact, seem to provide substantial evidence of both transitory and persistent restrictive effects on SME lending. In some cases, the FSB’s conclusions do not seem to be supported by any analysis or data, thus sounding like dogmatic statements.

This raises the questions: could an “overly-punitive” approach to the lending activity, particularly when considering the profound cultural differences between European countries, have contributed to the increasing social malaise that has affected important sections of the population? And if this is the case, what could happen if the regulations are made even more stringent?

As an Italian and a European citizen, I can only hope that some brilliant economist will be able to distance himself from the still prevailing view of strictness at all costs, modelling the negative impact on growth, and that some courageous and clear-headed legislator will have the courage to act with determination, so as to establish a more even-handed approach, that takes into account the distinctive characteristics of each European economy. This could also allow Italy to gradually move forward towards the cultural change needed to ensure long-term sustainable growth.